Inventory turnover can refer to anything from how long a box of cereal sits on a grocery store shelf to the frequency with which a mutual fund manager buys and sells securities. Calculating inventory turnover ratio is relatively simple and the necessary information is readily available. Knowing the rate of inventory turnover gives you insight into a business’s management efficiency or investment fund’s philosophy.
Inventory Turnover Defined
Inventory turnover ratio, also called inventory turns, measures the cost of goods sold as a proportion of the value of a firm’s average inventory. Put another way, this ratio tells you how many times each year a business uses up and replaces its inventory. The yearly cost of goods sold is stated near the top of a company’s income statement, which you’ll find in its annual report. The value of inventory is located in the assets section of a company’s balance sheet, also published in the annual report.
Figuring the Turnover Rate
To compute an inventory turnover ratio, divide the cost of goods sold by the average inventory value. Calculate average inventory value by adding the inventory values from the current year and previous year balance sheets, and divide the sum in half.
Suppose a business reports its year’s cost of goods sold on the income statement as $1.5 million and you determine the average inventory equals $600,000. Dividing $1.5 million by $600,000 gives you an inventory turnover ratio of 2.5 times per year.
High and Low Inventory Turnover
Analysts compare inventory turnover ratios of similar companies because typical ratios vary from industry to industry. For instance, grocery stores with perishable stock normally have higher turnover ratios than dealers in durable goods such as home appliances. The important thing is that inventory turnover ratio indicates how well a firm manages its inventory. A low ratio may indicate excess inventory that can raise storage costs and increase the risk of outdated merchandise. However, excessively high ratios suggest the business may be prone to inventory shortfalls that can result in lost sales and unhappy customers.
Investment Fund Inventory Turnover
Inventory turnover ratio for an investment fund means something different than the turnover ratio of a business’s physical merchandise. For a fund, calculate inventory turnover by first subtracting short-term assets that mature in less than 12 months. Pick the lesser of the fund’s securities acquisitions or assets sold and divide by the average net value of the fund’s portfolio. According to Accounting Explained, low ratios of around 20 to 30 percent of net assets indicate the fund manager follows a “buy and hold” investment philosophy. Funds with ratios greater than 100 percent are likely to be run according to an aggressive investment strategy.